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Entrepreneur's Sale of Company Preferred Stock Results in Ordinary Income.
(Parker Tax Publishing December 08, 2013)

Income received by a taxpayer's S corporation in a Code Sec. 351 transaction with its subsidiary under a stock purchase agreement is reclassified as ordinary income under Code Sec. 1239 because the taxpayer's S corporation and its subsidiary were related persons for purposes of Code Sec. 1239. Fish v. Comm'r., T.C. Memo. 2013-270 (11/25/13).

In 1996, Gary Fish, a systems architect, started a technology business. Two years later, he incorporated the business, FishNet Consulting, Inc., as an S corporation. To find additional capital as his business grew, Gary retained a financial adviser to evaluate potential financial partners and possible sale of the company. In a letter of intent dated September 2004, private equity firm Edgewater Funds offered to purchase newly created preferred stock in FishNet Consulting representing 43 percent of the company's outstanding equity. In November 2004, Gary formed Fish Holdings, Inc., an S corporation. In a tax-free reorganization under Code Sec. 368(a)(1)(F), Gary contributed all his FishNet Consulting common stock to Fish Holdings in a Code Sec. 351 transaction. FishNet Consulting and Fish Holdings then executed Form 8869, Qualified Subchapter S Subsidiary (QSub) Election, to treat FishNet Consulting as a QSub. As a result of the QSub election, FishNet Consulting was treated as liquidating into Fish Holdings. In December 2004, Gary and Edgewater signed an agreement for Edgewater's purchase of the newly created preferred stock in FishNet Consulting. FishNet Consulting changed its name to FishNet Security and authorized the issuance of common and preferred stock. Each share of common and preferred stock was entitled to one vote. Its amended articles of incorporation provided certain restrictions: (1) the company could not engage in certain actions without prior consent of a majority of preferred shareholders, and (2) the common shareholders elected three out of the five board of directors, with one of the three directors being independent. The creation of preferred stock terminated FishNet Consulting's S corporation status and QSub election.

FishNet Security paid one-time dividends to Fish Holdings of (1) $2.5 million, and (2) $9,463,000, the sale proceeds from the stock purchase agreement. In the transaction, Fish Holdings was deemed to have contributed all the assets and liabilities of FishNet Consulting (the QSub) to FishNet Security (the newly created C corporation) in exchange for common stock and cash (the sale proceeds from the purchase agreement). The transaction was tax-free to the parties with respect to the stock, but the cash proceeds were taxable boot to Fish Holdings. After closing the purchase agreement, Fish Holdings owned all of FishNet Security's common stock and Edgewater owned all its preferred shares.

On Form 4562, Depreciation and Amortization, attached to its 2005 Form 1120, U.S. Corporation Income Tax Return, FishNet Security reported Code Sec. 197 intangible and depreciable assets and claimed amortization and depreciation deductions. On its 2005 Form 1120S, U.S. Income Tax Return for an S Corporation, Fish Holdings reported the $9,463,000 dividend distribution as long-term capital gain and that characterization flowed through to Gary's individual tax return. The IRS determined that the dividend distribution was ordinary income to Gary.

Code Sec. 1239 provides that gain on the sale or exchange of property that is depreciable to the transferee is treated as ordinary income if the transaction is directly or indirectly between related taxpayers. An amortizable Section 197 intangible is treated as property subject to depreciation. Related taxpayers include a person and an entity that person controls. A controlled entity is defined as a corporation more than 50 percent of the value of the outstanding stock of which is owned, directly or indirectly, by or for such person.

OBSERVATION: The recharacterization of gain under Code Sec. 1239 applies only to gain that is recognized. Thus, in the case of a tax-free exchange, the rule applies only to the extent of any gain recognized on the exchange.

Code Sec. 1563 defines a controlled group as one or more corporations connected through stock ownership with a common parent corporation if the common parent owned either (1) more than 50 percent of the total combined voting power of all classes of stock entitled to vote or (2) more than 50 percent of the total value of shares of all classes of stock of the other corporations.

To apply Code Sec. 1239 to the distribution of sale proceeds from FishNet Security to Fish Holdings, the Tax Court had to determine whether Fish Holdings and FishNet Security were related persons for purposes of Code Sec. 1239. Specifically, the court was asked to decide whether Fish Holdings owned either more than 50 percent of the total combined voting power of all classes of FishNet Security's stock entitled to vote or more than 50 percent of the total value of shares of all classes of FishNet Security's stock.

The Tax Court held that Fish Holdings and FishNet Security were related persons under Code Sec. 1239(b) and the dividend distribution to Fish Holdings and reported by Gary was taxable as ordinary income. After the stock purchase agreement closed, Fish Holdings owned all of FishNet Security's common stock, which was two-thirds of the outstanding shares of stock entitled to vote. Thus, on the basis of record ownership, Fish Holdings owned more the 50 percent of FishNet Security's voting stock. The court cited Hermes Consol., Inc. v. U.S., 14 Cl. Ct. 398 (1988), which found that voting power includes the ability to approve or disapprove fundamental changes in the corporate structure and elect the corporation's board of directors. In this case, Fish Holdings had 50 percent voting power with respect to fundamental corporate changes and could elect 60 percent of the FishNet Security's board. The independence requirement for the one director was not a restriction that reduced its voting power below 50 percent since Fish Holdings was the only shareholder entitled to elect the independent director.

According to the court, the basis for FishNet Security's valuation of the Code Sec. 197 intangibles for purposes of the stock purchase agreement was the goodwill created by Gary. Moreover, Gary continued to have primary control of the company's business after purchase agreement closed. The court also found that Fish Holdings owned more than 50 percent of total value of shares of all classes of FishNet Security's stock at the time the purchase agreement closed. The court relied on the use of the preferred stock's redemption price by the IRS's expert as the appropriate valuation of the preferred stock. Thus, under the voting power and valuation control tests of Code Sec. 1563(a)(1), the court concluded that Fish Holdings and FishNet Security qualified as related persons for purposes of Code Sec. 1239, and the distribution to Fish Holdings was ordinary income to Gary.

For a discussion of the special rules relating to the characterization of gain on sales of depreciable property between related persons, see Parker Tax ¶119,105.(Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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